Vox column: Re-evaluating the result that the costs of “leaning against the wind” exceed the benefits, January 24, 2017.
The IMF and the Federal Open Market Committee have both suggested that the costs of ‘leaning against the wind’ exceed the benefits. This Vox column responds to claims that the results of my research backing up this conclusion could be overturned. It argues that the alternative assumptions necessary to overturn the result are unrealistic, and that the finding that the costs of the policy exceed the benefits therefore seems to be robust.
The column summarizes “How Robust Is the Result That the Cost of “Leaning Against the Wind” Exceeds the Benefit? Response to Adrian and Liang.”
“Leaning against the wind” (LAW) with a higher monetary policy interest rate may have benefits in terms of lower real debt growth and associated lower probability of a financial crisis but has costs in terms of higher unemployment and lower inflation, importantly including a higher cost of a crisis when the economy is weaker. For existing empirical estimates, costs exceed benefits by a substantial margin, even if monetary policy is nonneutral and permanently affects real debt. Somewhat surprisingly, less effective macroprudential policy, and generally a credit boom, with resulting higher probability, severity, or duration of a crisis, increases costs of LAW more than benefits, thus further strengthening the strong case against LAW.
Leaning-against-the-wind monetary policy may lead to a Fisherian debt deflation, since it may lower prices below the anticipated level and therefore raise real debt above what was anticipated. This is what the Riksbank has done by keeping average inflation significantly below the inflation target for a long period. This has caused household real debt to be substantially higher than it would have been if inflation had been on target. Link to Vox column.
New Vox column: Is the Riksbank neglecting the price-stability objective, counteracting full employment, and increasing household debt?